The Panama Papers : save the baby, not the bathwater

11 million highly confidential documents were leaked anonymously from a secretive law firm in Panama that allegedly links a large number of heads of state and other public figures with clandestine bank accounts in offshore tax havens [if you have not already, read all about it here, and here].

The information leaked can have far reaching implications ranging from destabilizing governments to permanently damaging other institutions like FIFA (even more than the rampant corruption already has). The populist response has been to ask for a clamp down on these so called tax-havens and shell companies because of their rampant misuse.

While there is a need for increased regulation, I would urge all concerned to head down that path only after much deliberation for at least three reasons.

1. Tax havens are generally good, but anonymity generally is not

There are legitimate reasons for tax havens to exist beyond their illicit uses. In some instances tax havens allow investors to take advantage of structures that allow them to avoid paying capital gains taxes in countries where they derive profits. Currently investors in certain emerging markets expect these tax free gains to compensate them for the additional risks they take. They use “pooling vehicles” structured as shell companies in tax havens via private equity funds and hedge funds and in some cases special purpose vehicles that own real assets. If tax havens are abolished, these investors’ expectations of pre-tax returns could exceed realistically achievable levels which in turn would constrain capital flows and curb global growth in the medium to long run.

The problem is not in the existence of tax havens but in the anonymity they have co-promoted. If regulators could enforce transparency and layer-upon-layer of obfuscation can be avoided, legitimate capital and accountability will flow freely but illicit wealth will not.

2. Most of us benefit from tax havens, mostly unknowingly

If you look closely at your brokerage accounts, pension accounts and insurance policies, the companies behind them frequently use these tax havens to derive tax benefits (and juiced investment returns) I describe in Section 1. If you are a school teacher in Ontario or a fireman in California, your pension fund is likely taking advantage of these structures already.

3. Some of the largest tax havens are in your backyard, not on an exotic island

20% of the tax-haven business globally is based in (surprise!) Delaware in the US. Global financial centers like London, Singapore and Hong Kong are also significant centers of tax avoidance activity. According to the Tax Justice Network [more detail here]:

These are the 10 most significant secrecy jurisdictions in the world, in the opinion of the Tax Justice Network: the U.S. (Delaware), Luxembourg, Switzerland, Cayman Islands, the U.K. (City of London), Ireland, Bermuda, Singapore, Belgium and Hong Kong.

Wanton over-regulation of these markets is much more likely to impact major world economies directly than the indirect benefits derived from blocking capital flows through these so called tax havens.

Regulation is not easy; any attempts should be measured

Countries globally are unlikely to implement regulations uniformly. When the US implemented the Foreign Account Tax Compliance Act (FATCA), the well intentioned regulation made US sources of capital unfavorable relative to others from Western Europe or China and they were turned away from lucrative opportunities overseas.

And yet there are well accepted standards that most responsible countries globally have agreed to when it comes to anti-money-laundering (AML) initiatives. What we need is more carrots and more sticks to get almost all countries to conform with and enforce these AML standards to combat illicit use of tax havens and shell companies.

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